Interpreting internal control (ICOFR) weaknesses in stock research
CLVT, PLUG, JAMF and others recently reported material weaknesses
Should you care about material weakness disclosure? When and why?
Clarivate (CLVT), a $10B analytics company headquartered in London, recently announced errors in prior period financials that required restatement. Eeek! In their 10-K filed last week, they reported material control weaknesses related to modifications of compensation agreements and to the review of tax balances at companies they acquired.
Restatements and material weaknesses in internal controls are relatively rare at companies the size of Clarivate. Clarivate’s Chief Accounting Officer stepped down just three days before the 10-K was published, indicating the severity of the situation.
Over the course of the annual reporting season, I’ve gotten multiple questions about the importance of material control weaknesses and how to interpret them. I used to specialize in SOX internal control testing at KPMG. This guide is designed to help you better understand what’s happening behind the scenes.
In this post we explain internal control weakness disclosures in context and highlight new material weaknesses at U.S public companies (scroll to the bottom).
Internal control weaknesses have an association with future downside events. However, some internal control weaknesses are more serious than others. This guide helps you tell the difference.
How frequent are internal control weaknesses at public companies?
Smaller companies are much more likely to report control weaknesses. So far in 2022, about 15% of small cap issuers in the U.S. have disclosed a material weakness in internal controls in their 10-K. Of the small caps reporting material weaknesses, more than one in five were Special Purpose Acquisition Companies (SPACs). Conversely, less than 3% of large cap issuers reported a material control weakness so far in 2022.
Material weakness disclosure is clearly more notable for companies with larger market caps. Large cap offenders this year include Clarivate, CBRE Group, Plug Power and NXPI Semiconductors. For more details on large material weaknesses scroll to the bottom.
What are internal controls over financial reporting (ICFR) anyway?
Internal controls are the systems and processes to make sure that the financial statements are correct. Internal controls include really basic things like making sure that employees can’t easily move millions of dollars out of the company’s bank account into their own pockets and making sure the same person doesn’t review their own work.
When do companies have to disclose a material weakness?
A material weakness in internal controls means there was a failure in the company’s systems or processes that could have resulted in a misstatement in their financial statements, that you, the investor, would care about. The word “material” describes information that actually matters to an investor’s decision.
Companies are likely to disclose a material weakness when:
They restate their financial statements. ICFR are designed to prevent errors in the financial statements. If incorrect financial figures were reported to investors, clearly the internal controls were not working. In the case of a restatement, the existence of a material control weakness is a “no duh” situation.
The external auditors catch an error that the company’s management team didn’t catch themselves. This means there was an error in the company’s financial reporting. The error was caught before the financial statements went out to investors but only by an external party! A public company should never rely on their auditors to catch their mistakes. Why not? Auditors are imperfect and can’t check everything. (I should know.) If a company has errors in one area of their reporting, it’s less likely that the management team is taking the care required to report high quality financial (and operational) information to their investors.
The finance team isn’t big enough or the financial processes aren’t robust enough to check all of the boxes required for a public company. This is the least severe level of internal control weakness (although still not a good thing). This type of internal control weakness is considered more acceptable/expected at small or new companies.
When are material control weaknesses most problematic?
Specific/detailed control weakness disclosure is more concerning because it indicates that the auditors likely found an error in that account. The implication is that the company’s reporting may be less reliable and, in some cases, that the management team isn’t setting the right tone at the top.
Look out for control weakness disclosure discussing revenue or accounts receivable accounts. Revenue is one of the most common accounts targeted for manipulation or exaggeration. Investors tend to care a lot about revenue growth and it impacts other important metrics like gross margin and EBITDA. Control weaknesses over revenue are often more concerning and severe.
Material control weaknesses are more severe when there’s more than one. If the disclosure describes weaknesses found in multiple areas e.g. both accruals and inventory, that’s a bigger deal. If the company discloses material control weaknesses for multiple years in a row, that’s also a bigger deal.
When material weaknesses co-occur with other risk factors, they matter more. This goes without saying, but a new control weakness is more concerning in the presence of other problems or risks.
When do control weaknesses matter less?
Weaknesses in internal controls are considered less severe when they are fixed right away and don’t come back. The process of fixing these weaknesses is called “remediation”. Look out for companies that disclose detailed steps for remediation and subsequently take action on those plans.
Control weaknesses are also more forgivable in the first year as a public company, especially for small companies. Issues like not having the right IT controls in place or enough financial staff to review complex transactions tend to be more common in these instances.
Interested in exploring material weakness disclosure reported in 2022?
Look no further. Here is a sample of recent material weaknesses disclosed by public companies. See if you can determine which control weaknesses are more severe and less severe. Let us know in the comments!
Large Cap Control Weaknesses (summarized):
CLARIVATE PLC (CLVT) | 2022-03-10 | $11B - CLVT recently had to restate prior period financial statements because they found errors. They also reported material weaknesses related to modifications of compensation agreements and to the review of tax balances at companies they acquired.
CBRE GROUP INC (CBRE) | 2022-03-01 | $30B - CBRE reported material weaknesses related to revenue and receivables control processes at an operating segment they call “GWS EMEA”.
NXP SEMICONDUCTORS NV (NXPI) | 2022-02-24 | $50B - NXPI disclosed material weaknesses related to IT controls.
PLUG POWER INC (PLUG) | 2022-03-01| $15B - PLUG reported control weaknesses related to the presentation of expenses, accruals and adjustments to inventory.
Other larger companies with material weaknesses in the last few years include Coupang, Stanley Black and Decker, Toast, Roblox, Olaplex Holdings and GoodRx.
Small & Mid Cap Control Weaknesses:
FASTLY INC (FSLY) | 2022-03-01 | $1.9B - “…we and our independent registered public accounting firm identified material weaknesses in our internal control over financial reporting for the years ended December 31, 2021, 2020, 2019 and 2018, some of which were newly identified in the year ended December 31, 2021 and one was originally identified in prior years and remains partially unremediated for the year ended December 31, 2021.
The material weaknesses related to the lack of sufficient qualified accounting resources, lack of timely and complete identification of internal-use software costs for capitalization, and a system implementation of our stock plan administration system.”
JAMF HOLDING CORP (JAMF) | 2022-03-01 | $4.2B - “Specifically, we did not have controls over (i) the communication of commission plan changes between the sales and accounting teams to identify and correctly account for commission plan changes in the financial statements and (ii) reviewing the evaluation of various terms in the commission plans to the relevant accounting guidance. As a result, sales and marketing expenses were understated and deferred contract costs were overstated in prior periods. This material weakness resulted in the revision of our previously issued consolidated financial statements as of and for the years ended December 31, 2020, 2019, and 2018 and for each of the quarters during the years ended December 31, 2020 and 2019 and the quarter ended March 31, 2021.”
BEAUTY HEALTH CO (SKIN) | 2022-03-01 | $2.63B - “The material weaknesses were related to segregation of duties, including the review and approval of journal entries, our lack of sufficient accounting resources and the lack of a formalized risk assessment process…. Our management has concluded that these material weaknesses in our internal control over financial reporting are due to the fact that we were a private company with limited resources…”
ZIFF DAVIS INC (ZD) | 2022-03-15 | $4.8B - “The control activities were not designed to allow the Company to timely identify and account for (i) a debt exchange with a third-party lender that resulted in a loss on extinguishment of existing debt, (ii) the unrealized gain on the Company’s remaining 19.9% investment in Consensus, and (iii) the completeness and accuracy of certain amounts classified in discontinued operations in the consolidated financial statements.”
COLICITY INC (COLI) | 2022-03-01 | $420M - “In consultation with the audit committee of our board of directors, we previously concluded that the financial statements and other financial data as of and for the periods ended March 31, 2021 and June 30, 2021, as well as the Form 8-K filed on March 4, 2021 should no longer be relied upon and should be restated to report all Public Shares as temporary equity and net income (loss) per share pro rata between our Class A and Class B common stock..”
ATI PHYSICAL THERAPY INC (ATIP) | 2022-03-01 | $360M - “These material weaknesses resulted in adjustments to income tax (benefit) expense and deferred income taxes and related disclosures as of and for the year ended December 31, 2021.”
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